Martin Wolf: "Those Who Hope for Swift Return to Normalcy" are "Deluded"

Well, that isn’t exactly how the Financial Times’ Martin Wolf put it, but his comment today does carry a sobering message. Bank balance sheets need a tremendous amount of additional shoring up.

Some not too pretty factoids:

We appear to be less than halfway through writedowns, and the fundraising and recapitalizations to date are falling short of the equity hits. Wolf thinks the ability to raise funds privately is nada.

Banks also have significant maturing debt in 2010 and 2011. If they can’t roll it at an attractive price, that means balance sheet shrinkage. And believe it or not, the myriad of lending support programs represents only 1/3 of the IMF’s estimate of total needs. Yes, the US has the FDIC guaranteeing bank bond issues; it will probably expand that program further. But if that continues (likely) it again continues the dangerous pretense that banks are private concerns that claim the need to give employees decent pay, when they are in fact wards of the state and should be regulated as utilities. or put into receivership and restructured.

The gloomy calculus does not include the implosion of the shadow banking system, a bigger source of credit than the banking system. Unless private securitization can be restored (ahem, no progress on the needed reforms), even more capital in the banking system is needed.

One thing that Wolf does not allow for is that some shrinkage in credit is necessary, if nothing else due to the fact that people who were not creditworthy got loans. But that presumably shows up mainly in the contraction of non-bank credit.

Wolf is nevertheless optimistic that the fiscal cost (13% of US GDP) is manageable. But is it politically viable? The restructuring of Japan’s banks was delayed nearly a decade due to popular hostility. Continued rescues of banks are more and more difficult to sell politically as the unwashed public keeps being reminded that we pay for the losses but the perps get to keep the gains.

And the finesses are running into opposition too, although at this point it’s just a rumble. For instance, the Senate version of the budget resolutions contained language calling for the Federal Reserve to identify banks and other financial institutions that have received more than $2.2 trillion in taxpayer-backed loans and other financial assistance since March 24, 2008. A letter to John Spratt signed by Alan Grayson, Ron Paul, Walter Jones, Corrine Brown, Michelle Bachmann, and Peter Defazio asked for the Senate language to be incorporated in the House version:

Under Chairman Bernanke, the central banking system has opened a range of extraordinary funding facilities that are providing additional credit to banks, large financial institutions, and primary brokers, as well as guaranteeing commercial paper. All of this activity is happening in secret, with the Federal Reserve disbursing money and credit to the large financial institutions that have put our credit markets and economy at risk. The Federal Reserve has resisted FOIA requests, and will not make public even the terms of payment for the contractors it is using to run these extraordinary programs.

At the very least, Congress and the public should have knowledge about which banks are receiving taxpayer money, what they are doing with the money, and the credit risk taxpayers are taking on through the Federal Reserve. The Senate language encourages such transparency, allowing for audits and public disclosure of secret loans and financial assistance from the Federal Reserve to these large institutions.

The more the Fed acts as what Willem Buiter calls “a quasi-fiscal agency of the Treasury”, the more turf struggles we will see over its role and accountability.

From the Financial Times:

The International Monetary Fund’s latest Global Financial Stability Report provides a cogent and sobering analysis of the state of the financial system. The staff have raised their estimates of the writedowns to close to $4,400bn. …

To put this in context, the writedowns estimated by the IMF are equal to 37 years of official development assistance at its 2008 level…

The IMF estimates the additional equity requirements of the banks as well. It starts from total reported writedowns up to the end of 2008, which come to $510bn in the US, $154bn in the eurozone and $110bn in the UK. The capital raised to the end of 2008 is, again, $391bn in the US, $243bn in the eurozone and $110bn in the UK. But the IMF estimates additional writedowns in 2009 and 2010 at $550bn in the US, $750bn in the eurozone and $200bn in the UK. Against this, it estimates net retained earnings at $300bn in the US, $600bn in the eurozone and $175bn in the UK.

The IMF points out that the ratio of total common equity to total assets – a measure investors burned by more sophisticated risk-adjusted ratios increasingly trust – was 3.7 per cent in the US at the end of 2008, but 2.5 per cent in the eurozone and 2.1 per cent in the UK. The IMF concludes that the extra equity needed to reduce leverage to 17 to 1 (or common equity to 6 per cent of total assets) would be $500bn in the US, $725bn in the eurozone and $250bn in the UK. For a 25 to 1 leverage, the required infusion would be $275bn in the US, $375bn in the eurozone and $125bn in the UK.

In current dire circumstances, the chances of raising such sums from markets are zero. Part of the reason is that they could still prove to be too little…..

Yet these are not the only sums required. Governments have so far provided up to $8,900bn in financing for banks, via lending facilities, asset purchase schemes and guarantees. But this is less than a third of their financing needs. On the assumption that deposits grow in line with nominal GDP, the IMF estimates that the “refinancing gap” of the banks – the rollover of short-term wholesale funding, plus maturing long-term debt – will rise from $20,700bn in late 2008 to $25,600bn in late 2011, or a little over 60 per cent of their total assets (see chart below). This looks like a recipe for huge shrinkage in balance sheets. Moreover, even these sums ignore the disappearance of securitised lending via the so-called “shadow banking system”, which was particularly important in the US.

The IMF also provides new estimates of the ultimate fiscal costs of rescue efforts (see chart below). At the high end are the US and the UK, at 13 per cent and 9 per cent of GDP, respectively. Elsewhere, costs are far lower. These, happily, are affordable sums. Indeed, compared with the recession’s impact on public debt, they look quite manageable…

A better reason for refusing to bail out banks is its dire effect on incentives. The alternative must then be bankruptcy. Jeremy Bulow of Stanford University and Paul Klemperer of Oxford University have advanced a scheme that would do this neatly. Valuable banking functions of each institution would be split off into a new “bridge” bank, leaving liabilities (apart from deposits) in the old bank. Creditors left behind would be given equity in the new bank. Governments could “top up” some creditors beyond this level, without making all creditors whole, as now.

Respectable opinion assumes that it would be best to provide full bail-outs of creditors in systemically important institutions. The rationale for this is that it is the only way to eliminate further panic. The objection is not the fiscal cost. It is that a limited number of large, complex and “too-big-to-fail” institutions would then emerge. Their creditors would naturally believe they were lending to governments. This would be a recipe for yet bigger catastrophes in future years.

Yet imposing large losses on creditors is indeed risky. It would probably have to be done simultaneously everywhere. Only after it was obvious that surviving banks were sound would anybody be willing to lend to them without guarantees.

Even worse than this choice between grim alternatives is the fact that the path to recovery is likely to be slow, whichever is chosen. As the latest World Economic Outlook notes in an important chapter, recessions that follow financial crises are unusually severe. So, too, are globally synchronised recessions. But now we are living through a globally synchronised recession that coincides with a huge financial crisis that emanates from the core countries of the world economy, particularly the US. This is a recipe for a long recession and a weak recovery. Whatever is done about the financial system, “deleveraging” is the order of the day (see chart). The UK’s position in this looks dire. But that of the US looks quite bad, too, even compared with that of Japan in the 1990s.

For better or worse, the authorities have decided to bail out their financial systems with taxpayer money. Almost all the affected countries should be able to afford to do this, at least on the IMF’s numbers. So now, having made the fundamental decision to prevent bankruptcy, they must return their financial systems to health as swiftly as they possibly can.

Even so, that will prove to be a necessary, not a sufficient, condition for a return to robust economic health. The overhang of debt makes deleveraging inevitable. But it has hardly begun. Those who hope for a swift return to what they thought normal two years ago are deluded.